The Financial Accounting Standards Board's new proposal regarding purchase accounting doesn't solve everything. However, it would eliminate the pooling method, and it takes a stab at dealing with goodwill in a way that could make more sense.

What should investors think of the Financial Accounting Standards Board's (FASB) new proposal on purchase and pooling accounting?

The FASB, the organization that makes U.S. accounting rules, last week made a drastic change to its earlier proposal to eliminate the pooling of interest method of accounting for business combinations.

Before we get to the change, a little background. U.S. Generally Accepted Accounting Principles (GAAP) permit two accounting methods for business combinations: purchase and pooling. Under the purchase method, any premium paid in excess of the acquired company's book value that can't be assigned to a category of intangible assets (such as patents) gets recorded as goodwill. Companies don't like this since goodwill has to be amortized, which means it flows to the income statement and is deducted from income.

Under the pooling method, the balance sheets of the two companies are combined, no goodwill is created, and therefore net income isn't reduced by periodic amortization expenses. Lots of companies use the pooling method when allowable, for obvious reasons -- they don't want to see net income reduced as the byproduct of a big acquisition.

The FASB originally proposed eliminating the pooling method. Why? For starters, it doesn't make much sense to have two methods for recording essentially the same transaction -- especially when the two methods produce vastly different results on the financial statements. At the very least it makes investors scratch their heads. At worst it makes comparing firms that use different methods nearly impossible.

Unfortunately, since the FASB proposed eliminating pooling there has been a firestorm of protest from corporations and politicians. The idea behind some of the protest is that we'd see fewer acquisitions if pooling were eliminated since investors wouldn't understand why net income drops after a big-time merger.

I don't have much sympathy for this argument. First, most investors would probably be better off if there were fewer acquisitions at enormous premiums. Second, companies shouldn't act as though investors are only capable of reading the income statement. The fact that accounting net income is often a poor indicator of financial reality isn't exactly hidden in the pharaoh's tomb. Everyday, more and more investors understand the value of reading all three financial statements (the balance sheet, the earnings statement, and the statement of cash flows) in unison to understand a company's economic situation.

Under the FASB's most recent proposal, pooling would still be eliminated yet companies wouldn't have to amortize goodwill unless the asset becomes impaired. In other words, that premium wouldn't count against earnings unless something happened that made it clear the goodwill isn't worth what the acquiring company paid for it.

There are critics of pooling who view the FASB's latest proposal as capitulation to corporations and politicians, while proponents of pooling see the proposal as a meaningful compromise. What's the truth?

My initial take is that the FASB compromise is a good move. It's clear the organization would have struggled overcoming political opposition to the initial proposal. The issue was such a hot potato that Congress jumped in and started drafting legislation to stop the board from eliminating pooling. Maybe this isn't the best resolution, but it's a step in the right direction.

Next, there are a number of issues the proposal does address.

There are two aspects of pooling that give investors headaches. First, the assets and liabilities of the company being acquired (one company is always buying another) don't get marked up to market value, which often understates their true value and can inflate earnings. Second, since no goodwill is recorded on the balance sheet, there's no record on the financial statements of how much the acquiring company really paid for the assets. Eliminating pooling would change all that since, in purchase accounting, assets and liabilities have to be marked up to fair value and goodwill is recorded on the balance sheet.

One valid criticism of purchase accounting, however, is that goodwill is often amortized arbitrarily. There are cases where the goodwill paid for a company appreciates in value, yet if a company is forced to amortize goodwill then its financial statements distort that reality: Goodwill is recorded as shrinking in value when it is actually growing.

The FASB's proposal addresses this because it doesn't force companies to amortize goodwill unless it becomes impaired. In that sense, the FASB is making an effort to align financial statements with economic reality.

There are plenty of folks who strongly disagree with this take. Steven B. Lilien, accounting professor and chairman of the Stan Ross Department of Accountancy at Baruch College in New York, thinks it's a big mistake to record an item like goodwill on the balance sheet and not allow its effects to flow through to the income statement. He thinks it makes more sense to amortize the goodwill and let investors make their own decision whether the expense should be added back. Otherwise, it's just another layer of soot on financial statements that already lack transparency.

In a New York Times story by Floyd Norris last week, Edmund Jenkins, FASB chairman, said the board must develop a tough impairment test. I think that story, and Jenkins' comments, hit the nail on the head. The effectiveness of the new proposal depends on the impairment test the FASB devises. If companies can wiggle around the standard, investors are in trouble. If we end up with companies paying nutty prices for tired assets that just linger on the balance sheet unimpaired, purchase accounting will become a joke.

For example, in November 1998 America Online (NYSE: AOL) agreed to acquire Netscape in a pooling of interest transaction valued at $4.2 billion. Netscape at the time had a book value of $394 million. Now, everyone understood Netscape was probably worth a lot more than book value in late 1998. Since the acquisition, however, the Netscape brand name has all but disappeared, and many of the company's talented programmers have left AOL, including creative whiz Mark Andreesen. What else was the goodwill for if not brand name and programming talent?

If a goodwill premium had been recorded on the balance sheet at the time, AOL would have been amortizing goodwill against earnings all along. If the new FASB proposal were in effect and a useful impairment test existed, AOL would perhaps have been required to write off a portion of that goodwill premium against earnings, and investors would be able to see the financial effects of a pricey merger that yielded flimsy results, at least relative to the price paid.

I like that kind of accountability. As it stands, any premium paid under the pooling method is dust in the wind, and no one really knows what the assets are worth since they're recorded on the balance sheet at historical cost. I like financial statements with a better memory. Hopefully, the new FASB proposal will get us there. It doesn't fix every problem. Comparing financial statements for companies that use the purchase method can still be a bear, but I view that as less of a problem.

Meanwhile, the FASB is still reviewing details of impairment tests and may open the issue up again for public comment.